Explosion of global debt and fall of real interest rates into negative levels should continue to benefit gold investors
Paul Wong | February 10, 2020 | SmallCapPower: Our 2020 Top 10 Watch List is informed by the events of 2018 and 2019. We are in the very late-cycle phase of the longest economic expansion in U.S. history. Debt has exploded and with it, the deficit. The next crisis will likely occur when debt servicing obligations become stressed. The path of least resistance to address this will be to bring real interest rates further into very negative levels. And extreme negative real interest rates erode the value of almost all assets except one: gold.
(The following is an article originally published on sprott.com on February 4, 2020)
#1. Gold Bullion Breaking Above $1,600
We highlighted this chart in our December commentary, but the importance of surpassing the last significant chart resistance level is critical. Once exceeded, the $1,600 to $1,800 trading range opens up, and after that, if macro conditions continue as we expect, new highs are likely within a few years.
Figure: Gold Bullion Reaches Last Major Resistance Level
Source: Bloomberg. Data as of 2/03/2020.
#2. Gold Stocks Should Continue to Rally with Gold Bullion
We highlighted this in December as well. Breaking through GDX’s $31.32 highs of August 2016 is likely to put in place a very bullish multi-year base pattern and will target the next significant resistance at $39.50. We have discussed before how, as the price of gold bullion rises, gold companies’ earnings rise even more. Also, we emphasized several broad market valuation metrics; gold companies compare quite favorably to the general equity market. When the general equity market is at peak earnings power, gold mining companies are just starting their upcycle. One undeniable factor remains investor sentiment. After several years in a bear market and only now emerging into the bullish phase, gold equity sentiment is improving. A multi-year base bullish breakout will help lift sentiment.
Figure: Gold Equities Approach Major Resistance Level
A successful breakout will put in place a multi-year bullish base pattern.
Source: Bloomberg. Data as of 2/03/2020.
#3. U.S. Dollar Weakness
We are seeing signs of an intermediate peak in the U.S. dollar (“$USD”), as we highlighted in December. We see $USD weakness as the next driver for higher gold prices. Historically, the correlation of gold to a weaker $USD is very significant. Gold as a store of value will increase as the base denominated currency weakens.
Figure: The U.S. Dollar Poised to Head Lower?
The DXY appears to have completed its Wave B and is setting up for the Wave C lower to the lower channel range of 90. Note the negative divergence on MACD and RSI rolling over.*
Source: Bloomberg. Data as of 2/03/2020.
*Moving Average Convergence Divergence (“MACD”) is a trend-following momentum indicator that shows the relationship between two moving averages of a security’s price. Relative Strength Index (“RSI”) is a technical indicator used to measure the current and historical strength or weakness of a security.
#4. U.S. 10-Year Real Yields
Since the September 2019 peak in gold, real interest rates as measured by the 10-year TIPS yield, traded flat while nominal yields, breakevens and 5Y/5Y inflations swaps staged at least some measure of a rebound. The 10-year TIPS yield is already close to rolling over into deeper negative territory. The Fed has previously stated that even if inflation were to surpass its 2% inflation target, it would keep rates low, the definition of a negative real yield policy. During the next stress event or crisis, we expect the 10-year TIPS yield to plunge.
Figure: Real Interest Rates and Gold Bullion
Source: Bloomberg. Data as of 2/03/2020.
#5. Mean Reversion in Volatility
At the beginning of 2019, volatility was very high, and since then it has compressed to record low levels, mainly due to central bank easings and liquidity injections. There has been a clear and stunning decoupling of the economic outlook and market volatility. Whether you are looking at currency, bond or equity volatility measures, they have collapsed in unison. One example that stands out is the significant short position in VIX5 futures. CFTC VIX Futures have recently posted a record short position. It appears a considerable counter-position to this short is a long VIX future two months or more out. In other words, there is a large long VIX +two months position, short one month position trade, which has set up a feedback loop as the VIX decreases, the S&P 500 Index6 goes up. When the mean reversion arrives, the unwinding of this trade will impact the broad equity market.
Figure: VIX Index and VIX CFTC Net Positioning
Source: Bloomberg. Data as of 2/03/2020.
#6. The Cost of Credit Default Insurance
Credit default swap (“CDS”) spreads have fallen to their lowest level since the 2008 financial crisis and reveals yet another disconnect that we see in the markets. The cost to insure a default is too low, given that we are at the late-cycle phase of the longest U.S. economic expansion in history with record debt and deficit levels, a slowing economy, heighten policy and political risk. Figure 8 shows an average of several prime brokers’ CDS spreads. Prime broker CDS spreads are likely the most sensitive financial measure to the risk of credit default.
Figure: Prime Broker CDS Spreads at a New Post-2008 Lows
Source: Bloomberg. Data as of 2/03/2020.
#7. Nominal Yields Rangebound at the Lower End
Using the U.S. Treasury 10-year as a reference, we see nominal yields mostly rangebound at the lower end with risk to the downside far outweighing the risk to the upside. We highlighted in our December commentary some of the arguments for this. If this proves correct, it will provide significant base support for gold bullion.
Figure: U.S. 10-Year Yields
We saw a similar setup the last time the Fed began an interest rate cut cycle. Growth has slowed as we enter the late cycle. Going forward, we see an asymmetrical path for interest rates, as the hurdle rate for the Fed to raise interest rates is likely impossibly high relative to decreasing rates.
Source: Bloomberg. Data as of 2/03/2020.
#8. Global Liquidity
The incredible expansion of the Fed’s balance sheet in the last few months of 2019 was and continues to be the main driver for the unrelenting equity market advance. The balance sheet was expanded via short-term Treasury bills to address reserve bank imbalances. Since the end of August, the monthly average balance sheet growth has been $101 billion, well surpassing the $85 billion per month rate of QE3.
This expansion in liquidity has been responsible for all the stock market advance since the summer. The trailing 12-month S&P 500 earnings rolled over in August. Since then, the S&P 500 has diverged from earnings and is trading almost lockstep with liquidity (measured here with a proxy for Global Money Supply). Without earnings support, the market is more vulnerable to any factor or event that would cause a multiple contraction.
Figure: S&P 500 Overlayed with Global Money Supply ($USD Billions), and S&P 500 12-Mo. Trailing Earnings
Since August, the entire advance in the S&P 500 has been by P/E (price-earnings) expansion.
Source: Bloomberg. Data as of 2/03/2020.
#9. Gold Equity to Gold Bullion Ratio
This ratio broke out of its multi-year downtrend last year and continues to base build in a bullish manner. When this ratio breaks out past this previous significant resistance level, it will mark a decisive turn in investor sentiment. We have discussed the improving valuation metrics of gold equities in prior commentaries.
Figure: GDM Index to Gold Bullion Ratio
This ratio has broken out of a 12-year bearish down channel. As gold bullion advances and bullish price support firms, we see gold mining equities eventually outperforming bullion given their operating and financial leverage.
Source: Bloomberg. Data as of 2/03/2020.
#10. Heightened Geopolitical Risk and a Pandemic
It is difficult to monitor and foresee the risks of geopolitical events, as they tend to be short-lived and spike volatility before fading. Still, there is always the risk that events spiral out of control — the same with a viral outbreak. The market data which we have listed above will reflect the impact of geopolitical uncertainty and viral epidemics. The consequences of a geopolitical risk event or a pandemic spiraling out of control will be dire, especially when we consider the current background. Stock markets are at record peaks with very high valuation multiples and high expectations. Global economies are slowing in the very late stages of a very long prolonged economic cycle. There are record debt and deficits, and central banks already pushing the limits of monetary policy.
All this bodes well for gold bullion and gold equities in 2020.
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